How to find ‘turnaround’ stocks

JackHough

Investors trying to squeeze extra returns out of an aging bull market might want to consider some “turnaround” candidates.

These are companies that have stumbled badly, whether because of missteps or outside events, but now look cheaper than their projected profits warrant.

There are two reasons to embrace such companies. The first is that the returns can be big for investors who choose well. Nine companies in the Standard & Poor’s 500-stock index have beaten mighty Apple’s 67% gain this year, and several of them are best known for recent struggles.

Home builders PulteGroup
PHM, -0.94%
up 132%, and Lennar
LEN, +0.62%
up 73%, are digging their way back from a spectacular housing-market crash. Clothier Gap
GPS, +0.46%
up 95%, has closed weak stores and rekindled sales growth. And Sprint Nextel
S, -0.21%
up 112%, has recently shifted from large market-share losses to modest gains.

The second reason to seek out turnaround candidates is diversification. As famed Fidelity stock-picker Peter Lynch explained in his 1989 book “One Up on Wall Street,” ups and downs for turnaround stocks are less tied to broad market movements. That is a perk for investors who expect the 3 1/2-year stock rally to slow or stall.

One place to shop for turnarounds in the making is among stocks that trade cheaply relative to fundamental measures of value like price/earnings multiples. For example, the median S&P 500 company trades at 15 times projected earnings for its current fiscal year. But about 80 of the index’s 500 members sell for 10 times earnings or less.

Next, suggests Larry Pitkowsky, manager of the $195 million GoodHaven Fund, study the flaws of such companies to find either of two situations: those in which the crowd is wrong about its negative thesis or where the price already more than reflects a negative outcome.

For example, Pitkosky likes Hewlett-Packard
HPQ, -1.30%
which sells for four times earnings, and says most investors focus too narrowly on its slipping personal-computer sales. That division contributes just 15% of pretax operating profit.

The company’s new chief executive, Meg Whitman, is cutting staff and writing off underperforming assets while investing in research, cloud computing and data analysis.

Investors also should study turnaround candidates for elements of change, including new management and new strategies, says Peter Langerman, chief executive of the $60 billion Mutual Series funds owned by Franklin Templeton.

Langerman points to software maker Symantec
SYMC, -0.79%
which sells for 12 times earnings after a stock price gain of more than one-quarter since the end of June. “It has a history of overpriced acquisitions, but there’s a new chief executive and plenty of room to sell assets and improve margins,” he says.

A tarnished image for a company can be a turnaround hunter’s friend if it leaves the stock price unduly low. The Oakmark Fund, which ranks among the top 3% of balanced large-company funds for five-year performance, according to Morningstar, bought shares of insurer American International Group
AIG, +0.20%
earlier this year.

William Nygren and Kevin Grant, who manage the fund, called AIG a “poster child” for the financial crisis in a June letter to investors--a reference to the massive government bailout AIG received. The U.S. Treasury Department remains the company’s largest stockholder, raising concerns that as it sells the share price could suffer.

AIG’s price of more than $33 a share is safely above the $28.73 that the Treasury Department calls its break-even price. But the company already has reduced the Treasury’s stake to 53% from 92%, in part by selling business units and repurchasing the Treasury’s shares. On Sunday, Treasury announced another stock sale that would reduce its ownership to less than 20%. Read related story: AIG bailout profits came at a price.

Langerman of Mutual Series calls AIG a classic turnaround candidate. “They’ve divested the operations that got them into trouble,” he says, “and the stock sells at a deep discount to the value of remaining assets.” Shares are up more than 40% this year.

Mutual-fund investors also might consider Pitkowsky’s GoodHaven Fund, which launched in April 2011 and is off to a strong start, with a total return of 15% from its inception through Wednesday, versus 9% for the S&P 500 during the same period.

Pitkowsky and co-manager Keith Trauner previously worked as portfolio managers at the Fairholme Fund, which is known for embracing deeply unloved stocks and ranks among the top 1% of large-company value funds for 10-year performance.

GoodHaven has no upfront sales charge and costs 1.1% of assets per year--moderate for a fund of its type.

Investors who buy turnaround stocks shouldn’t fall in love with them. If the valuation rebounds to average market levels, or if signs mount that efforts to improve aren’t working, it is time to sell.

Also, fund investors should expect a bumpy ride from turnaround-heavy portfolios. Fairholme was one of the worst performers in its group last year but has been one of the best this year, and some of the same stocks that get the blame get the credit, including AIG, Sears Holdings
SHLD, -2.57%
and Bank of America
BAC, -0.84%

That sort of turbulence will keep most investors away. But to ones who like shopping for turnarounds, that is the whole point.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.